2 Summary When interest rates fall, many home owners enjoy the benefit of lower repayments on their mortgage. But they are also likely to find that the cost of their Compulsory Third Party (CTP) insurance policy has increased. It is not widely understood how and why the two events are related. When insurers be they private or publicly owned collect premiums, they hold this money to pay future claims. This money is invested in order to generate income for the insurer. The longer the investment period, the greater the significance of investment income as a source of revenue, and thus the insurer s ability to reduce the initial premium paid by customers. CTP and Workers Compensation claims involve injured people and are therefore complex, often taking years to resolve as a person s medical condition must first stabilise. On average, CTP claims are paid around five years after the premium is collected, making the investment income highly significant for CTP insurers. As interest rates or more specifically, bond rates fall, the implications for insurers are material. When economic conditions result in a drop in the yields of Australian Federal Government bonds, CTP and Workers Compensation premiums can be expected to rise. This is precisely what has occurred in Australia in the 12 months from June 2011 to June 2012 as the three year bond yield has halved. The nature of the global economy is such that seemingly unrelated external events can have an impact. The Greek debt crisis may be half a world away but it s been pushing up the price of your CTP premium. The degree to which premiums are able to respond to this price pressure is very much determined by the particular regulatory framework. 2

3 Background Each state and territory government in Australia administers their own CTP scheme. Many of Australia s CTP schemes are publicly underwritten, meaning the state or territory government sets the price, holds the risk and pays the claims. Two of the largest, New South Wales (NSW) and Queensland, have private underwriting and multiple insurers operating within their CTP schemes. The Australian Capital Territory (ACT) has a privately underwritten scheme but NRMA is currently the only provider. All remaining jurisdictions are publicly underwritten. The brands that offer CTP insurance in NSW or Queensland include Suncorp, GIO, AAMI, NRMA, RACQ, Allianz, Zurich and QBE. Another class of insurance that involves personal injury claims is Workers Compensation. CTP and Workers Compensation are referred to as long tail classes as they take significantly longer on average for the claims to be finalised than short tail classes such Motor and Home insurance. Whilst only one of several factors that impact premium rates, investment income is far more significant for long tail insurance classes than short tail classes due to the average duration of the claims. The dynamics discussed here regarding CTP insurance are equally relevant to Workers Compensation and Liability classes of insurance. Whilst investment income is of greater importance to long tail classes due to longer average claims durations, it is relevant to all general insurance classes. Investment income and premiums CTP and Workers Compensation insurance classes are capital intensive. A single catastrophic claim can cost tens of millions of dollars and take decades to resolve. This means that vast amounts of money (reserves) have to be held to pay future claims. For example, Suncorp estimate that insurers operating in the Queensland and NSW CTP schemes currently hold around $15 billion in reserves, risk margin and capital. Despite being largely invested in relatively low-risk and low yielding instruments, the revenue generated from this investment is significant. This has a noticeable impact on CTP and Workers Compensation premiums. In simple terms, if an insurer knows it needs to have $100 to pay a claim in five years time, it only needs to put aside $78 if the relevant bond yields are 5% 1. The investment by insurers of the money set aside to pay future claims reduces the premiums paid by CTP and Workers Compensation customers. If insurers did not generate investment income, a CTP premium of $315 would cost $390 2, assuming a 5% bond yield and scheme dynamics similar to the Queensland CTP scheme. What goes down A primary investment instrument for CTP and Workers Compensation reserves is Federal Government bonds. These bonds are also the benchmark used for accounting purposes when insurers calculate their reserves and future claims liabilities. As bond yields change over time, so should CTP and other long tail premiums. The actuarial rule of thumb is that for every 1% drop in bond yields, insurer premiums have to rise around 4% to remain sustainable. If, as has occurred recently, bond yields slump from 5% to 2.5%, then rather than putting aside $78 to pay a $100 claim in five years, an insurer would have to put aside $88 an increase of 13%. The same drop in bond yields means that a $315 CTP premium would have to rise to $350 in order to remain sustainable a $35 or 11% increase. 1 Bond yields vary depending on the length of maturity of the bond, with a longer maturity typically giving a high yield. The yield curve can be simplified to a single rate commonly referred to as the discount rate. 2 The total paid by a CTP customer typically includes levies and taxes in addition to the insurer premium. This calculation refers to the insurer premium only. 3

4 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan An insurer that has a robust duration matching investment program will significantly reduce the impact of changing bond yields on their existing liabilities. The issue for CTP and Workers Compensation insurers when bond yields drop is the fact that the premiums derived from policies being written today may be insufficient to cover future claims cost. Of significance is the ability of private insurers to respond when bond yields change. Changing the premium 5-year bond yields (%) 2000 to 2012 This volatility is one of the core challenges faced by all CTP and long tail insurers. A key mechanism to limit the ability for this volatility to dramatically affect the financial viability of an insurer is through locking in investments so they mature when the claims costs are due. This process is referred to as duration matching. Duration matching Given that an insurer s reserves (money set aside to pay future claims) and liabilities (the estimate of future claims costs) are often in the billions of dollars, there s considerable risk that large holes can appear in the balance sheet when bond yields change. For private insurers, the Australian Prudential Regulatory Authority (APRA) requires all liabilities to be fully funded, meaning that any hole in the balance sheet has to be filled immediately. When reserves are insufficient to cover liabilities then this gap has to be filled, which is referred to as reserve strengthening. This reduces the profitability of an insurer, and the impact can be dramatic hence the practice of duration matching. In simple terms, if the insurer expects to have a $500 claims bill due in three years, they will purchase a bond that will mature on average in three years to a total value of $500. By adopting an investment strategy of duration matching, insurers can protect their balance sheet and reduce the volatility of their year-on-year results. CTP and Workers Compensation are highly regulated classes of insurance. A key feature is that insurers cannot refuse to offer CTP insurance to a customer, which ensures that everyone can obtain insurance as long as they can pay the premium. In the jurisdictions where CTP insurance is underwritten by private insurance companies (Queensland, NSW and the ACT) the government regulators maintain a high degree of control over premium rates. The mechanism through which this control is exercised differs between Queensland and NSW. Queensland In Queensland the Motor Accident Insurance Commission (MAIC) manages a pricing process that is undertaken every three months. The process begins with the MAIC inviting insurers to provide a submission outlining their analysis of the trends and factors influencing CTP premiums and providing recommendations on appropriate adjustments to pricing. The MAIC also obtains independent actuarial advice, and then sets an upper and lower price limit for each of the 24 classes of vehicle. All insurers are then required to file their rates for each vehicle class, ensuring that their rates are within the band as prescribed by the MAIC. In Queensland, insurers nominate a single premium rate for each vehicle class. This means that all customers owning the same class of vehicle will pay the same CTP premium regardless of their age, location or driving history. 4

5 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11 Jul-12 Jun-02 Apr-03 Feb-04 Dec-04 Oct-05 Aug-06 Jun-07 Apr-08 Feb-09 Dec-09 Oct-10 Aug-11 Jun-12 Accompanying the price for each vehicle class, insurers also provide their projected profitability for the quarter. NSW The process in NSW is regulated by the Motor Accidents Authority (MAA). Whilst the MAA does issue mandatory premium filings on occasion, an insurer can provide a submission to change their premium rates any time. Most insurers tend to submit rate filings between two and four times a year. Unlike Queensland, no upper and lower price limit is set, but a complex formula plays a critical role determining premium rates. Insurers in NSW are able to charge different premium rates for the same class of vehicle. Factors such as how old the vehicle is, where it is garaged, the age of the driver and their driving history can all be used to determine the level of risk. Mature drivers with a clean record will tend to be charged less, while young drivers who have had accidents will have a higher CTP premium. The result is a degree of correlation between the risk and the premium paid, whilst maintaining affordability for high-risk drivers by having them effectively subsidised by low-risk drivers. For an insurer to change its CTP premium rates it must submit its proposed rates to the MAA, accompanied by its projected profitability. The MAA will then either approve or decline the new premium rates. Premium trends An examination of CTP premiums over the last decade presents an interesting story. The average NSW Class metro 1 premium decreased for the first half of the last decade, but has increased significantly since the onset of the global financial crisis. $500 $450 $400 $350 $300 $250 Insurers determine a base rate for each vehicle class and are then able to discount or increase the premium depending on their assessment of the risk. The MAA formula restricts insurers in the degree of discount or loading they can apply in relation to their base rate. A maximum of 15% discount 3 and loading of between approximately 25% and 45% can be applied, depending on what the formula stipulates. The formula ensures that if an insurer wishes to reduce its rates to attract more low-risk drivers, it will also have to reduce rates for high-risk drivers. Further, the proportion of customers to whom a particular insurer can offer discounts is limited by the formula to ensure each insurer is providing cover to a reasonable spread of both high and low risk drivers. 3 The 15% discount from the base rate is referred to as the headline rate and applies to drivers under 55 years of age. Drivers 55 and over may be eligible for a maximum discount of 25%. NSW average Class 1 metro CTP premium In Queensland the Class 1 4 upper price limit set by the MAIC has gone from $357 in 2003, down to $272 in 2007, up again to $347 in 2009 and then down again to $313 in $370 $350 $330 $310 $290 $270 $250 QLD CTP Class 1 Upper Price Limit (inclusive of levies and GST on insurer premiums) 4 Approximately 68% of vehicles registered in Queensland are Class 1. 5

6 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Significantly, from October 2010 to March 2012, the upper price limit remained at $313 for six quarters, before rising $5 in April 2012 to $318. In July 2012 an adjustment to fees and levies resulted in an 80 cent increase. A further $5 rise in the upper price limit to $ has been approved for the October 2012 quarter. $450 $400 $350 $300 $250 Investment income is just one ingredient, but when bond yields change rapidly and significantly, it becomes a highly influential ingredient. From January 2011 to July 2012, five-year bond rates have dropped from approximately 5.2% to 2.5% QLD CTP Class 1 Upper Price Limit (inclusive of levies and GST on insurer premiums) This contrasts with the changes in the NSW average metro Class 1 premium for the period from March 2010 to June 2012 where the average Class 1 metro premium rose from $422 to $ $500 $450 $400 $350 $300 $250 NSW average metro Class 1 CTP premium Premiums and bond rates Multiple factors influence CTP premiums including accident rates, inflation, scheme design and the efficiency of claims management. 5-year bond yields (%) Jan 2011 to July 2012 Adopting the rule of thumb that stipulates a 1% drop in bond yields requires a 4% rise in premium to compensate, this 2.7% drop would necessitate approximately a 10.8% rise 6 to maintain profitability 7. Over that same period the CTP upper price limit in Queensland has risen by $5.80 or 1.9%. The additional $5 rise that will take effect in October 2012 will take the total rise to $10.80 or 3.5%. By comparison, in NSW from December 2010 to June 2012 the average metro Class 1 premium has risen by $23 or 5% from $460 to $483. Further MAA-approved price rises have occurred since June, due in significant part to the dramatic decline in bond yields over the previous 18 months. As bond yields have dropped, prices in NSW have steadily risen, yet in Queensland prices have remained relatively flat. Competition Given these statistics, it perhaps comes as no surprise that insurers in Queensland are becoming 5 When comparing CTP premium rates between schemes, it is necessary to consider the benefits each scheme provides to injured people. Average CTP premiums are higher in NSW in comparison to Queensland, reflecting additional benefits such as the Lifetime Care Scheme that covers at fault drivers in NSW. No equivalent exists in the Queensland scheme. 6 The ACT CTP regulator approved a 10% rise in CTP premiums, effective September A partial offset to the upward pressure lower bond yields put on insurance premiums is the downward pressure that the same economic conditions that reduce bond yields put on average weekly earnings, which in turn reduces personal injury insurance premiums. 6

7 increasingly vocal in regard to the need to have premiums increase as investment returns drop. There has consistently been minimal difference between the prices of various insurers in Queensland far less variation than has occurred in NSW where no upper price limit is set and competitive market forces are able to operate more freely. bond yields that can stem from both domestic and international financial conditions. Given this exposure, private insurers arguably have a right to expect CTP premiums to respond to significant and sustained changes in bond yields. Since 2009 there has been a reduction in the degree to which insurers are filing rates below the upper price limit set by the MAIC. From January 2011 to January 2012, of the six participating insurers, four consistently filed at the highest permissible Class 1 price, with AAMI and Allianz filing no more than $6 below this upper price limit. For the last three quarters (April, July and October 2012) all six insurers have filed at the Class 1 upper price limit, meaning that there is effectively zero price competition in the Queensland CTP Class 1 market. Since the first of April 2012, all Class 1 motorists have paid exactly the same CTP price regardless of which insurer they chose the maximum price permitted by the MAIC. The MAIC policy of minimal rises in the CTP upper price limit has contained prices in Queensland, but it has come at the expense of competition. Sustainability State and territory governments have the power to determine how much motorists pay for their CTP insurance. In publicly underwritten schemes, if the price is set too low, the scheme is at risk of falling into deficit and having a negative impact on the government s balance sheet. This has occurred recently in the NSW Workers Compensation scheme, where a deficit of over $4 billion has emerged, due in significant part to a reduction in investment income from declining bond yields. This unsustainable financial position has led the NSW Government to undertake reform and cut benefits in order to contain further premium rises. In privately underwritten CTP schemes, it is insurance companies that hold the risk and have their balance sheets exposed to fluctuations in 7

8 Conclusion The relationship between bond yields and CTP prices is well understood by insurance analysts. It is a direct relationship and has a material impact on the financial sustainability of CTP insurers, both public and private. Private insurers that participate in CTP schemes are required by the Australian Prudential and Regulatory Authority to have sufficient reserves to cover all future claims. When bond yields drop, if premiums do not correspondingly rise then it s shareholders who pay to fill the gap between reserves and liabilities. An unresponsive regulatory framework reduces competition and undermines confidence in a private insurer s ability to operate sustainably in a CTP scheme. It is in the interests of the community to ensure that, even if bond yields crash, a viable CTP scheme is there to support Australian motorists who do the same.. The Suncorp Group Suncorp Group Limited and its related bodies corporate and subsidiaries (collectively Suncorp ) offer a range of financial products and services including banking (Suncorp Bank), general insurance, compulsory third party (CTP) insurance, workers compensation insurance, life insurance and superannuation (Suncorp Life) across Australia and New Zealand. Suncorp has around 16,000 employees and relationships with over nine million customers. Suncorp Commercial Insurance (CI) provides a wide range of business insurance products to small and medium sized businesses as well as corporate customers. These products are distributed nationally both directly and indirectly through intermediaries. CI provides workers compensation insurance in Western Australia, Northern Territory, the ACT and Tasmania, and operates in the managed fund scheme in New South Wales. CTP insurance is provided in New South Wales and Queensland. CI offers a wide range of insurance products and distributes them under the Suncorp, Vero, GIO and AAMI brands. Note: The information contained in this article should not be considered as legal, accounting financial or other professional advice or opinions on specific matters or facts and should not be considered as making any recommendation to take up a particular financial services product. Any financial product advice is provided by Suncorp-Metway Ltd and does not take account of any persons particular circumstances. 8

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